On March 19, Minister of Finance Bill Morneau presented the 2019 federal budget. The budget contained four key items that are relevant for the asset management sector:
- Allocations to redeemers
- Cross-border securities lending arrangements
- Derivative forward agreements
- New alternatives for managing pensions and retirement savings
Allocations to redeemers
Many funds have adopted an allocation to redeemers methodology that allows a fund to treat part of the amount paid to a redeeming unitholder as a distribution of the fund's net income rather than proceeds for the redeemed units. This approach is intended to provide a more equitable allocation of a fund's income amongst its unitholders than would otherwise be the case, particularly where a fund has realized significant gains or income on the disposition of assets required to pay the redeeming unitholder.
The budget proposes a new rule that will deny a mutual fund trust a deduction in respect of the part of an amount allocated to a redeeming unitholder that exceeds the capital gain that would otherwise be realized by the unitholder on the redemption of units if:
- the allocated amount is a capital gain; and
- the unitholder's redemption proceeds are reduced by the allocation.
In addition, a mutual fund trust will not be allowed to deduct an amount allocated to a redeeming unitholder if (i) the allocated amount is ordinary income and (ii) the unitholder's redemption proceeds are reduced by the allocation.
These proposals will apply to taxation years of mutual fund trusts that begin on or after March 19, 2019. This will apply to a fund's 2020 taxation year. Note, however, that a fund involved in a 2019 section 132.2 fund merger could be affected in 2019.
Although these proposals are aimed at specific deferral and character conversion strategies, they have broader implications. Asset managers should consider the following:
- Determine which funds have adopted an allocation to redeemer methodology and understand the details of how it works, as described in the relevant fund's declaration of trust. Identify cases where the methodology does not restrict the allocation to the amount of unrealized capital gains on the redeeming unitholder's units. Some funds simply limit the allocation to the value of the redeemed units. It is also critical to determine whether the funds allow for the allocation of ordinary income to redeemers, not just capital gains.
- Examine the proposal dealing with the allocation of ordinary income, which could be a concern for funds with significant investments held on income account, as can be the case with funds taking synthetic positions using certain derivatives. Also, consider funds that invest in non-resident funds and include their income amounts under section 94.1 of the Income Tax Act, or that earn significant foreign dividend income from the underlying funds. Even a fund with a basic fixed income portfolio could be negatively affected.
- Consider the income vs. capital characterization of a fund's investments and the resulting nature of its income. Given that an allocation of income through the redeemer methodology can have adverse tax consequences, determine the confidence levels for the fund's positions.
- With a fund administrator, review how the cost amount of each unitholder's units are computed. In the case of a unitholder that holds units on capital account, the cost amount is the adjusted cost base of the units. Getting this amount right is critical to complying with the proposal that restricts the allocation of a capital gain to the redeemer's unrealized gain on the redeemed units.
- Think through the technical and practical implications of inadvertently making a mistake in applying the new rules such that a fund is denied a deduction for an allocated amount.
- Consider whether the added complexity of applying the allocation to redeemer's methodology affects the approach to the mock and year-end distribution process.
- Determine whether the company can rely on the allocation to redeemers methodology to create an equitable allocation of income to the same extent as previous years. Consider a change in the frequency of the fund's distributions and notice period, as well as the mechanics of handling large redemptions.
- Identify any significant discrepancies between a fund's inside and outside tax basis. In other words, consider how the adjusted cost base of a fund's investments (and the unrealized gain on its investments) compares to the adjusted cost base of unitholders' units (and the unrealized gain on their units). A fund that frequently uses subscription proceeds to pay out redemption proceeds may find that it has a significantly larger inside gain than the unitholders' gains. The new restrictions on the allocation to redeemers methodology may complicate the management of this discrepancy.
REITs should also consider these proposals because they apply to all mutual fund trusts. Asset managers may wish to make a submission to Finance if there are concerns about how the new rules will apply.
Cross-border securities lending arrangements
Funds that borrow securities from non-resident lenders — to facilitate short sales, for example — should review how the budget proposal in this area affects them. In summary, the budget proposes to change the manner in which Canadian withholding tax will apply to dividend compensation payments in respect of Canadian and foreign shares. A dividend compensation payment made by a Canadian resident that has borrowed a Canadian share will be treated as a dividend on the share and be subject to withholding tax based on that characterization. Similarly, a compensation payment made in respect of interest on a borrowed debt security will be treated as such for withholding tax purposes.
The budget also provides for this same treatment for purposes of applying tax treaties, in the case of interest where the arrangement is fully collateralized. These amendments apply to securities lending arrangements (SLAs), as defined by the Income Tax Act, as well as specified securities lending arrangements, which are generally defined as arrangements that are substantially similar to an SLA. Compensation payments paid or credited on or after March 19, 2019 are subject to these amendments, subject to limited grandfathering.
Derivative forward agreements
Derivative forward agreements (DFAs) were introduced in 2013 to curtail character conversion transactions. A property bought or sold pursuant to a DFA will give rise to ordinary income rather than a capital gain. Generally, an agreement to purchase a capital property can be subject to the DFA rules if:
- the term of the agreement exceeds 180 days; and
- the difference between the fair market value of the property when it is acquired and the amount paid for it under the agreement is attributable in whole, or in part, to an underlying interest (including a value, price, rate, variable, index, event, probability, or thing).
Given the breadth of the meaning of an underlying interest, the DFA definition also contains an exception (in paragraph (b) of the definition) meant to exclude commercial transactions that might be otherwise inappropriately caught by the DFA rules.
The budget proposes an amendment intended to curtail a specific type of character conversion transaction developed after 2013 that relies upon the exception. As amended, a taxpayer's agreement to purchase a capital property will not be eligible for the carve out in subparagraph (b)(i) of the DFA definition if the following conditions are met:
- the property is a Canadian security as defined in subsection 39(6) for the guaranteed capital gains election or an interest in a partnership the fair market value of which is derived, in whole or in part, from a Canadian security;
- the vendor of the property is a tax-indifferent investor or a financial institution; and
- it can reasonably be considered that one of the main purposes of the series of transactions or events, or any transaction or event in the series, of which the purchase agreement is a part is for all or any portion of the capital gain on a disposition of the Canadian security referred to above (occurring as part of the same series) to be attributable to amounts paid or payable on the Canadian security during the term of the purchase agreement as interest, dividends, or ordinary income of a trust.
The definition of a tax-indifferent investor was introduced into the Income Tax Act in connection with the rules regarding synthetic equity arrangements and includes tax-exempts and certain non-residents and discretionary Canadian resident trusts. Importantly, it also includes a partnership and certain trusts if more than 10% of the fair market value of the interests are held directly or indirectly through one of more trusts or partnerships by the preceding types of investors.
Although it will take time to fully consider the potential application of this change to commercial transactions, this amendment could have unintended implications, particularly in connection with deals involving partnerships with corporate subsidiaries, and possibly M&A transactions related to asset managers themselves. Managers of alternative funds — including private equity funds — should carefully consider all potential issues.
This amendment will apply to transactions entered into on or after March 19, 2019, with grandfathering similar to that which applied when the DFA rules were first introduced.
New alternatives for managing pensions and retirement savings
Budget 2019 introduced advanced life deferred annuities (ALDAs) and variable payment life annuities (VPLAs). These expand the investment alternatives available to Canadians.
BDO can help
The BDO tax team can help assets managers understand how the new budget may affect them and their funds. To discuss the items raised in this alert, or to discuss other issues affecting the asset management sector, please contact:
For more information on 2019 federal budget initiatives, read our full Budget 2019 coverage.
The information in this publication is current as of April 11, 2019.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.